The fast view

Structural and cyclical drivers could see de-dollarisation gathering pace over the next few years.

Our research looks at three potential scenarios and their investment implications.

Scenario one anticipates full renminbi internationalisation; scenario two looks at renminbi regionalisation; and scenario three involves a reduced role for the dollar.

The three aren’t mutually exclusive. But the most likely scenario is the second one, a managed internationalisation of the renminbi, with the focus on regionalisation among China’s close trading partners.

We anticipate a major geopolitical development that is likely to require a new approach to asset allocation, both globally and regionally.

While the dollar enjoys unipolar dominance, as outlined in Why the US dollar remains centre stage, the next currency transition may not necessarily result in a ‘winner takes all’ outcome. Our paper, What is driving de-dollarisation?, looks at the structural and cyclical drivers that could see de-dollarisation gathering pace over the next few years. Given the historical context, and structural and cyclical drivers, how should we expect the next global currency shift to pan out?

Three scenarios and their investment implications

1. A new global currency

Scenario one – a new global currency

In the first scenario, investor focus should be on Chinese capital account liberalisation because the subsequent movements in capital flows – both into and out of China – will be very large relative to the world economy. True, the well-known Chinn-Ito Index of financial openness shows that China’s capital account has not opened much in recent years. But were authorities to move in this direction, the outcome would be substantial. For now, China’s liberalisation is largely focused on allowing foreign money into China more easily rather than permitting Chinese capital flows abroad.

But ultimately, there will be vast flows in both directions. To anticipate the size of these flows, we update a Bank of England thought experiment from 2013 that assumes: China’s financial openness converges with other rich countries, catch-up growth in China continues, and there is a continued decline in home bias among Chinese consumers. On that basis, we estimate that China’s average of external assets and liabilities will rise from 8% of world output to 17% by 2030, impacting nearly every asset in the world.1

China’s financial integration is much lower than its trade integration

Source: Investec Asset Management, 2018

Investment implications for scenario one

The effects of full renminbi internationalisation will likely be more global than regional. Although China is already central to the global economy, capital account liberalisation will increase its systemic importance. If China’s financial walls are lifted, its vast pool of savings will participate in global capital markets, boosting global liquidity.

Chinese companies and households are underinvested in overseas assets and may diversify their savings by investing abroad. Similarly, foreign investors tend to have little exposure to China. Today, China’s average of external assets and liabilities currently amount to just over US$6 trillion. If China’s international investment position were to catch up with the United States, that figure would at least double by 2030.

For Chinese investors there is an opportunity for further geographical diversification and improved domestic asset allocations. The current split between equity and fixed income in China’s private sector portfolio assets will likely increase from the current 59-41% to something closer to the United States’ 72-28%. Financial intermediaries based in China who can earn the trust of domestic households to facilitate savings abroad will also gain from this trend.

In the same way that global investors monitor the investment preferences of Japanese households, they will have to pay closer attention to China’s savings trends. Chinese capital market liberalisation is a clear opportunity for foreign investors to diversify portfolios. For instance, Chinese equities have less than half the correlation to the rest of the world compared to other major indices. Foreign participation in China’s bond and equity markets was just 1.5% and 2% respectively at the end of 2017.2 That number is bound to rise. In April, the Bloomberg Global Aggregate Index will add local currency Chinese bonds to the index, representing around 5% of an index tied to over US$50 trillion in assets.3

Successful capital market strategies will therefore not only bank the diversification benefits, but also focus on how the Chinese system synchronises with the global financial system. Ultimately, that means paying close attention to Chinese financial conditions, and correlations between Chinese asset classes and foreign assets. A situation like 2018 where Chinese fixed income generated 7-10% while US government bond returns were negative, becomes less likely.

Finally, easing capital controls under the current conditions of financial repression would improve the return on household savings as Chinese citizens would have more investment options. But debt funding costs for private firms would likely increase. This is because domestic banks are still required to provide cheap loans to underperforming state-owned enterprises, and capital account liberalisation would force up deposit rates towards domestic lending rates.4 Investors capable of making the security selection and taking the credit risk to invest in these private firms would benefit.

2. Managed internationalisation

Scenario two – managed internationalisation

In the second scenario, China never fully opens its capital account. Instead, it spurs the creation of a new monetary system, in which the Chinese state re-asserts itself more than the market.

It is unlikely that China will simply slot into the existing monetary system. Historically, great powers have changed the nature of the financial system into which they have integrated. It is not a coincidence that the Bretton Woods system of fixed exchange rates was created after the United States emerged from the second world war as the main ordering power. Today, if China has its way, the renminbi may never become fully convertible.

This is consistent with China’s highly discretionary approach to capital management to date. In April 2015, former central bank governor Zhou Xiaochuan stated that the “capital account convertibility China is seeking to achieve is not based on the traditional concept of being fully or freely convertible … instead China will adopt a concept of managed convertibility.”5

Since then, managed convertibility has meant asymmetric intervention, where global investor inflows are permitted much more (via QFII, QDII, R-ODI, or QDLP schemes) than domestic outflows. At the end of 2015, for instance, Chinese residents were subject to tighter capital controls, while international investors were free to take funds out. China’s policy of managed convertibility would only have been amplified in late 2015 and early 2016 when hedge funds began shorting the offshore renminbi, which then produced a devaluation signal to other market participants.6

In any case, China’s preference for managed convertibility should not be too surprising. After all, it is not so long ago that the US had capital controls. For instance, the US Interest Equalisation Tax of 1963 was meant to make it less profitable for US investors to invest abroad to protect the balance of payments. This involved imposing a tax on foreign shares and bonds up to 15% of their purchase price.

What can we learn from the sterling bloc?

The last sustained example of an international currency with major capital controls was the sterling bloc centered on the United Kingdom between the 1930s and the 1960s. This came about following the economic crisis after 1929, when several countries pegged their currencies to the pound sterling to reduce volatility. By 1933, members of the sterling bloc included most of the British empire but also Denmark, Egypt, Estonia, Finland, Iraq, Iran, Latvia, Lithuania, Sweden, Norway, Portugal, Thailand, and others.

The parallel is inexact. China today is a rising power. The sterling bloc was created when the UK was in decline. Furthermore, the sterling bloc was established to manage and even hide British weakness, whereas renminbi regionalisation is designed to project China’s strength. Nevertheless, there are three potential similarities with the sterling bloc.

1. A reserve currency with capital controls

Most obviously, sterling was a reserve currency with capital controls, precisely the aim of Chinese policy. Sterling was not convertible outside the bloc. Countries were required to exert careful control on exchange within the sterling area, and payment of non-sterling exports was closely tracked.

Percentage share of sterling in total reserves (1950-1958)

1950

1951

1952

1953

1954

1955

1956

1957

1958

Iraq

95

80

81

86

91

84

80

71

66

Ceylon

89

73

78

67

73

67

56

53

47

Australia

82

66

65

70

64

49

58

65

55

Pakistan

78

79

52

57

59

62

53

50

44

India

73

69

69

97

97

98

56

44

33

New Zealand

64

61

62

73

69

61

72

63

66

South Africa

24

22

23

8

19

7

8

0

0

Source: Schenk, Britain and the Sterling Area, p. 30

2. Strong trade relationships

The bloc was underpinned by strong and complementary trade relationships. Throughout the 1950s, Iraq, India, Burma and South Africa – all of which were at this point politically independent of the UK – continued to conduct over 40% of their trade with the UK. The sterling area was a complementary system where the producers of food and raw materials would supply British industry in return for manufactured goods from British factories.

In a similar vein, China enjoys strong trade relations with its Asian neighbours. Chinese imports from Asia (Hong Kong, Japan, South Korea, India, and Southeast Asia) already account for 38% of its total trade. In sharp contrast, China’s trade with Latin America and Australia amounts to just 10% in total.7 Distance is still relevant to trade costs, and transport costs are still significant despite containerisation.

Regional composition of China's imports, 2017

Source: The Observatory of Economic Complexity, MIT, 2018

Moreover, China has been running persistent deficits with some countries in Asia, including South Korea, Thailand and Malaysia. This has enabled some Asian countries to accumulate the renminbi-denominated reserves needed to operate a renminbi-based system, another similarity to the sterling bloc.8

Chinese demographics also naturally favour a step change in trade relations with its Asian neighbours. As China ages, unskilled labour is becoming increasingly scarce relative to countries like Indonesia, India and Bangladesh. China will therefore export capital and goods that require skilled and semi-skilled labour, and import goods using raw materials, energy and unskilled labour – making those Asian countries natural trading partners. Consistent with this presumption, trade among the economies in question has been growing more rapidly than global trade, and faster than China’s trade overall.9

3. A complementary financial relationship

A complementary financial relationship managed by the central country is the third potential characteristic that the sterling bloc and a regional renminbi system might share. Capital controls helped the sterling area survive the second world war. During this period the UK borrowed heavily by using the commodity exports of its colonies to acquire dollars. In turn, the UK provided the colonies with foreign exchange via quotas. The sterling area bolstered British foreign exchange reserves and reduced the risk of a run on the pound for the UK.

However, the dependent countries also enjoyed some benefits. The sterling area provided access to the London capital markets for other members at a time of general capital controls that restricted access to other lenders. It also reduced exchange rate risk for most of the sterling transactions between partners during the 1950s.

The dynamics of this relationship may share some similarities to the current Belt and Road initiative, which allows China to project power overseas while promising countries trade and investment.

Not plain sailing

China’s policy of renminbi regionalisation will not happen overnight. For one thing, China’s efforts to restructure its economy mean it may be in for a difficult few years. Meanwhile, China will also need to overcome its neighbours’ distrust. A recent survey of 1000 government, academic, civil society and media elites in Southeast Asia found that only 10% thought China to be a “benign and benevolent power.”10 These factors will certainly affect the speed of any currency transition.

Investment implications for scenario two

The second scenario is effectively the status quo. Continued renminbi internationalisation within a partially closed capital account is our base case, as the Chinese authorities have clearly stated their aim is managed internationalisation.

Under a scenario of Chinese regionalisation, there will likely be a decline in risk premia in China’s trade partners due to a shift in China’s outbound investment. Investors should monitor signs of increasing regionalisation, as reflected in Chinese policy initiatives like the Belt and Road and the expansion of the People’s Bank of China swap lines. The Chinese central bank has already signed more than 30 swap agreements with emerging market countries to facilitate trade and offer downside protection in times of crisis.11

Such regional initiatives could lead to a general decline in risk premia in emerging Asia and reduce the boom and bust of the dollar funding cycle. A relevant parallel is perhaps Western European involvement in Eastern Europe, which has boosted overall investment and financial connections. It has been a gradual process that evolved after the fall of the Soviet Union. Initiatives include the establishment of infrastructure funds, portfolio investment and trade deals. The spread between nominal German and Hungarian 10-year bonds fell by 380 basis points in the 20 years to the first quarter of 2019, though the crisis in between also suggests that if unmanaged, the de-risking process can go too far.

The second broad impact to asset allocation is a transformation of Asian emerging market economic cycles. Dollar dominance is partly predicated on the fact that the dollar is still the default currency for trade, with 80% of dollar-denominated imports never entering the US. Economists have found strong invoicing effects from the dollar, where overseas economies’ trade, inflation rates and asset values exhibit great sensitivity to movements in the dollar.12 Increased invoicing in renminbi will cause other economies to trade more in line with China’s economic and financial cycles, boosting investment strategies that are aligned with this transformation.

3. A reduced role for the dollar

Scenario three – a reduced role for the dollar

Despite the dollar’s longstanding advantages, its dominance can be eroded. Under the third scenario, other countries increasingly take steps to reduce use of the dollar in invoicing, trade, and finance, thereby setting off a chain of events that eventually erodes dollar dominance.

As explored earlier, a dollar down cycle, geopolitical shifts, changes in energy market dynamics and structural shifts in China are already driving de-dollarisation. As these drivers gain momentum, currency multipolarity could become a reality. Depending on whether the euro and the renminbi have had time to internationalise, and can pick up the slack, a decline in dollar use could have a negative impact on global liquidity – just as the move away from the gold standard in the 1930s prompted a chaotic adjustment. By contrast, the 1971 collapse of the Bretton Woods system did not slow growth or undermine financial stability.

Two types of monetary collapse – 1930s or 1971Destructive or disruptive

Source: Eichengreen, B., “When Currencies Collapse: Will we replay the 1930s or the 1970s?” Foreign Affairs, February 2012.

Nothing is foreordained. The quality of US policy-making has a material impact on how multipolarity manifests itself. If the US maintains strong economic fundamentals and institutional strength, then the development of plausible alternatives to the dollar could even be a net positive. It would signal strength in the global economy.

How will a reduced role for the dollar impact the US?13

1

Higher US funding costs. As former US Federal Reserve chairman Ben Bernanke pointed out, any “exorbitant privilege” the US might have in funding has been eroded by the emergence of other credible currencies.14 Long-term real interest rates for US safe assets are generally no lower than those paid by other major advanced economies. Monetary tightening means they are currently substantially higher. A reduced demand for dollar assets would raise funding costs, implying tighter domestic spending constraints and lower living standards.

2

Lower seigniorage revenue. The US benefits from seigniorage revenue. This can be approximated as the difference between interest earned on securities in exchange for bank notes, and the costs of producing and distributing these notes. For the United States, currency held outside banks as of the third quarter of 2018 is around $1.6 trillion, of which perhaps half to two-thirds is held outside the United States. While interest earned on securities is obviously skewed by the US Federal Reserve’s quantitative easing programme, if a spread of 50-250 basis points were assumed given the low interest rate environment, the seigniorage income from dollar use outside the US would range from US$4 billion to $27 billion, or 0.02% to 0.13% of US output.15

3

Dollar depreciation. Dollar dominance results in increased demand for dollars, which pushes the dollar into overvalued territory. Moreover, the dollar is also exposed to further appreciation in times of stress, such as during the 2008-2009 crisis. The impact of a dollar depreciation would be mixed. It would result in higher inflation of imported goods and services. US exporters, however, would benefit from increased competitiveness thanks to lower production costs relative to the rest of the world. Domestic sectors that competed with imported goods and services would benefit from more expensive imports. Determining which effect predominates, will ultimately depend on the import and export price elasticities to the currency, and their pass-through rates (the extent to which exchange rate changes translate into price changes for the consumer).

4

More exposure to external shocks. A dominant dollar insulates the US from foreign shocks sparked by sharp fluctuations in other currencies. The prices of imports into the US are less affected by exchange rate fluctuations compared to goods imported into other countries. This means US inflation is more insulated from foreign developments. For instance, a yen depreciation of 10% relative to Japan’s trading partners raises prices in Japan by 9% after two years, implying a 90% pass-through rate in the long run. By contrast, the US numbers are around 4.4%, implying a 44% pass-through rate in the long run.16 Greater invoicing in other currencies would shift the burden back to the US. Meanwhile, more US entities would have currency mismatches on their balance sheets which would need to be managed.

5

Less influence in the world. The dollar has been a tool to secure US influence around the world. The Bretton Woods institutions of the IMF and the World Bank are a key channel, but another is the growing use of currencies in international negotiations. Examples include imposing sanctions and providing swap lines during crises. A weaker dollar would reduce US influence with other countries.

In summary, the impact of a reduced role for the dollar would erode the exorbitant privilege of the US by increasing long-term US funding costs, reducing seigniorage revenue, exposing the US to more foreign economic shocks, and reducing US influence in the world – all of which would ultimately affect US living standards.

Investment implications for scenario three

Under the final scenario of a reduced role for the dollar, we do not envisage a single event but rather a continuum of possible futures, ranging from a brief period of realignment to a general and systemic crisis. Here we focus on the most favourable development – a realignment instigated by a gradual reallocation of reserves and commodities into non-US currencies.

In terms of asset allocation, a secular weakening of the dollar would amplify existing trends that are bearish for the dollar, including late-cycle market behaviour, an anticipated convergence in US and non-US rates, and an expected dollar down cycle. The key opportunity lies in understanding that the change may be secular rather than cyclical. Signs of a shift out of the dollar could signify greater downside for the dollar over the longer term.

While gold could benefit, we may also see an increased allocation to safe-haven currencies with twin surpluses, just like in the 1930s when reserve managers turned to countries still on the gold standard – Belgium, France, the Netherlands and Switzerland. Between 1931 and 1933, the share of all foreign exchange reserves held in those countries’ currencies rose to 30% from 10%.

One scenario that is relevant today is a shift in the composition of reserve currencies due to rising US disengagement in international affairs. Some recent work based on pre-World War One data indicates that military alliances boost the share of a currency in the partner’s foreign reserve holdings by about 30 percentage points. In a scenario where that were called into question, research shows that around US$750 billion worth of official US dollar-denominated assets – equivalent to 5% of US marketable public debt – would be liquidated and invested into other currencies such as the yen, the euro or the renminbi, assuming stable composition of reserves. In turn, that could lead to long-term US rates increasing by as much as 80 basis points, with all the attendant disruption that would cause.17

Finally, the strength of the US dollar is a key predictor for rest of the world aggregate trade volume and inflation. A US dollar appreciation of 1% against all other currencies in the world predicts a 0.6-0.8% decline within a year in the volume of total trade between countries in the rest of the world, controlling for the global business cycle. Therefore, persistent US dollar weakness could be positive for global trade and inflation.18

In conclusion

After nearly seven years of a dollar up cycle and a de-rating in emerging market assets, investors should be aware that the nature of the opportunity unfolding could be structural rather than purely cyclical. In 1985, the United States arguably crossed the Rubicon from being the currency of a leading world creditor to a major world debtor. The US net foreign debt position has only grown since then, thereby undermining the fundamental basis of the dollar’s status as the primary reserve currency.

In anticipating what now plays out, it is worth keeping in mind that the three scenarios above are not mutually exclusive. For instance, it is possible that full Chinese capital account liberalisation occurs during a period of a prolonged dollar decline. Ultimately, we think the most likely scenario is the second one, a managed internationalisation of the renminbi, and specifically a regionalisation among China’s close trading partners. That is a major geopolitical development that is likely to prompt a decline in risk premia across emerging Asia as well as a general transformation of economic cycles in the region. As such, it is likely to require a new approach to asset allocation, both globally and regionally.

This content is for informational purposes only and should not be construed as an offer, or solicitation of an offer, to buy or sell securities. All of the views expressed about the markets, securities or companies reflect the personal views of the individual fund manager (or team) named. While opinions stated are honestly held, they are not guarantees and should not be relied on. Investec Asset Management in the normal course of its activities as an international investment manager may already hold or intend to purchase or sell the stocks mentioned on behalf of its clients. The information or opinions provided should not be taken as specific advice on the merits of any investment decision. This content may contain statements about expected or anticipated future events and financial results that are forward-looking in nature and, as a result, are subject to certain risks and uncertainties, such as general economic, market and business conditions, new legislation and regulatory actions, competitive and general economic factors and conditions and the occurrence of unexpected events. Actual outcomes may differ materially from those stated herein. All rights reserved. Issued by Investec Asset Management, March 2019.